A History of the Federal Reserve, Volume 2 (71 page)

Roosa initially opposed proposals to augment the gold stock and replace the dollar by creating an international means of settling payments imbalances. By 1965, he accepted the need for a multilateral agreement to augment the supply of gold. The Special Drawing Right (SDR) agreement provided for creating “paper gold” at the IMF.
¹⁶¹

In 1967, Roosa debated Milton Friedman, the leading exponent of floating exchange rates. As before, he defended fixed rates as a source of discipline on countries’ policies, without recognizing that the Employment Act in the United States and similar explicit or tacit agreements abroad necessarily limited the influence of international considerations in policymaking. Domestic policy concerns, especially concerns about unemployment, dominated.
¹⁶²

Roosa argued that, under fixed exchange rates, sustained payments deficits or surpluses showed underlying problems that led to correction by market adjustment. Further, “practical considerations . . . render a system of flexible rates unworkable” (Friedman and Roosa, 1967, 31). He rejected “frequent and regular increases in the gold price” or even wider bands (ibid., 35). The wider band idea might someday be of some use; the incremental gold price change would be “an unmitigated disaster” (ibid., 35–36). If exchange rate changes had to occur, rates for countries other than the United States “can and should be changed when there is a persisting disequilibrium under a fixed-rate system” (ibid., 39).

Roosa elaborated. “The most significant overall point to be recognized is that the United States can never expect . . . to bring about at its own initiative any effective change in its exchange rate” (ibid., 54). The reason: other countries would take offsetting action to defend themselves. This argument suggested that other countries would prefer to lend to the
United States rather than adjust. It is noteworthy that this argument was not unique to Roosa. It represented much conventional thinking at the time only three years before President Nixon closed the gold window and forced exchange rate realignment.

161. In Friedman and Roosa (1967, 10), Milton Friedman predicted that every country “will want a different agreement—one that permits it to borrow much and commits it to lending little. Thus, despite all the appearance of an agreement in principle, no effective agreement will in fact be reached.”

162. Roosa raised this point as a criticism of floating rates (Friedman and Roosa, 1967, 83), although he recognized elsewhere that in practice countries could not adjust by creating enough unemployment to reduce wages (ibid., 43). Of course, reducing unemployment was a main reason why the alternatives were floating rates or controls and restrictions to maintain the fixed rate system. As Friedman noted, controls and restrictions introduced uncertainty and costs, removing a main advantage of fixed ex
change rates (ibid., 22).

Roosa accepted the possibility of a “system-wide change in parities . . . simultaneously against gold” (ibid., 54). Though he did not rule this out, he wrote that it would “undermine confidence for the future in the stabilizing point of reference to which all other elements of the system are hinged” (ibid., 55–56). Later, he changed his mind and opined that the currency problem “cannot simply be solved by a change in the price of gold” (ibid., 64).

Much earlier, Irving Fisher had proposed to adjust the number of grains of gold to keep constant the gold price of a large basket of commodities.
¹⁶³
If the price level rose or fell the number of grains of gold required to buy the basket would increase or decline to stabilize the gold price of the commodity basket and the purchasing power of money. Benjamin Graham, J. M. Keynes, and others later proposed similar schemes. These proposals gave no reason for loss of confidence in the standard and avoided instability.

The debate established that there was no meeting of the minds. Friedman argued correctly that
“reserves
alone
cannot
do
the
job.
There must be some adjustment mechanism” (ibid., 11; emphasis in the original.) Roosa rejected all adjustment proposals. The main change he proposed was to augment the supply of reserves.

The French government complained frequently about the special role of the United States based on its ability to balance its accounts by supplying dollars that would be held in reserves by other countries. In fact, United States policymakers did not value the privilege highly. Instead, they took leadership of discussions to create an alternative currency that could serve as a reserve.

Discussion of monetary problems usually ignored the demand for dollars. Demand increased as trade and finance expanded. An ove
rseas market in dollars, called euro-dollars, based mainly in London, arose to avoid U.S. exchange restrictions and satisfy the demand for dollars.
¹⁶⁴
Bankers
lent and borrowed euro-dollars in an unregulated market. As in any banking market, producers of euro-dollars depended on a reserve held at a domestic U.S. bank, but the relation of the euro-dollar loan to the reserve balance in the United States was less structured than in regulated domestic markets. U.S. banks and corporations both borrowed and lent in the euro-dollar market. For example, when regulation Q ceilings were binding, corporate treasurers could increase earnings by lending surplus balances in the euro-dollar market. U.S. banks opened branches in London to service their customers and lend surplus balances at the higher interest rates available abroad. These actions reduced interest rate differences, so that euro-dollar rates soon moved to a small premium over domestic rates (Peter Fousek, “The Euro Dollar Market, Tighter Credit and the Balance of Payments,” Board Records, March 1, 1963, 7).

163. In 1922–23, Congress held hearings on Fisher’s proposal but did not adopt it (see volume 1, 182).

164. Euro-dollars are dollar deposits in banks domiciled in Europe (including branches of U.S. banks). The euro-dollar started as a way for the Soviet Union to hold dollar deposits without subjecting themselves to regulation or possible blocking by the United States government. Interest rate ceilings in the United States expanded the market in the 1960s and 1970s.

Much comment suggested that the euro-dollar market was inflationary because it created additional money that the Federal Reserve could not control. This argument lacked analytic substance. Euro-dollar deposits depended on deposits or reserves of domestic banks. Banks or financial institutions that created dollar liabilities without any reserve of dollar assets risked large losses when forced to cover claims. Euro-dollars were simply another of the many ways that financial markets innovated to better serve their customers.

Federal Reserve staff did not share the popular view that euro-dollars represented a net outflow that increased the U.S. payments deficit. Their 1963 report noted that U.S. corporations borrowed in the market and that foreigners borrowed to finance purchases of U.S. goods, services, and assets. Also the higher interest rates that the market paid induced foreigners to hold additional dollar deposits. “It is not possible to conclude with any assurance whether the net overall effect so far has been favorable or damaging to the dollar” (ibid., 10). The report expressed concern that “the market is developing in a direction unfavorable to the dollar” (ibid., 10).
¹⁶⁵
In fact, much of the borrowing and lending appears to have been used to finance activities in the United States when regulation Q ceiling rates were binding. The smallest part of euro-dollar market activities was the use of euro-dollar deposits as a substitute for deposits at U.S. banks (Bernstein, 1972).
¹⁶⁶

Capital market controls and fear of additional controls encouraged
growth of the euro-dollar market and other unregulated currency markets. Journalists, market participants, and some central bankers expressed concern that growth of these new credit market instruments seriously weakened monetary control of inflation. This proved to be a false conjecture on this as on many similar occasions. When central banks undertook to control inflation, they succeeded despit
e continued growth of the eurodollar market.

165. The main effect on the balance of payments came when foreigners borrowed eurodollars and invested them abroad.

166. Much of the concern about euro-market activity came from the rapid increase in euro-dollar deposits—a 37 percent compound rate of increase from December 1964 to December 1969. During the same period commercial paper outstanding in the United States
rose at a 30 percent compound annual rate without arousing similar concerns (Bernst
ein, 1972, 39).

Expansion
Without
Inflation,
1961–65

The years 1961to1965 are among the best in Federal Reserve history. The economy grew 17 percent; inflation (deflator) rose at a 1.6 percent average rate and, as late into the expansion as January 1965, the reported annual rise in the consumer price index was only 1 percent. After its usual slow decline, the unemployment rate fell below 5 percent in 1964 and reached 4 percent by the end of 1965. Contrary to administration beliefs, the economy reached full employment with low inflation.

Industrial production and stock prices rose. From the end of the recession in February 1961 to December 1965, both indexes increased 40 percent. Unit labor costs declined more than 7 percent, reflecting the increased productivity growth and low inflation for the period. Partly as a result, the balance of payments deficit fell to $1.3 billion (liquidity basis), the lowest annual value since governments restored currency convertibility.
¹⁶⁷

Table 3.7 shows that the United States continued to sell gold to foreign central banks and governments. The rate of gold loss slowed in 1963 and 1964, then surged in 19
65 with slower productivity growth, the reported increase in inflation to 1.9 percent by the end of 1965, and forecasts of 3.5 percent inflation by mid-1966 (Chart 3.3 above). Table 3.7 also shows
that higher monetary base growth accompanied or preceded higher inflation and the increased rate of gold outflow. Evidence of higher anticipated inflation also appears in long-term interest rates, shown in Chart 3.6 above. By the autumn of 1965 these interest rates had reached their highest level in the postwar years to that time. Base velocity rose, accompanying the increase in interest rates and anticipated inflation. Chart 3.10 shows the surge in base velocity beginning in 1965. For the years 1960–64, base velocity rose at a compound average rate of 2 percent. In 1965, base velocity rose nearly 4 percent. The Great Inflation had begun. Increased spending for the Vietnam War began the following year, intensifying the inflation problem.

167. The liquidity measure includes changes in liquid liabilities to foreign official holders and changes in official reserve assets.

START OF THE LONG EXPANSION

Despite the relatively high short-term interest rate and rising long-term real rates, the economy grew more than 6 percent in the four quarters ending in December 1961. Recovery slowed in second quarter 1962, and real output fell about 0.7 percent in the fourth quarter. Real GNP fell more than 2.5 percent below the Council’s forecast for the year.

Industrial production fell in the second quarter, then rose slowly for the rest of the year. The slowdown was not monetary. The proximate cause was said at the time to be uncertainty generated by a public dispute over steel prices between President Kennedy and the chairman of the largest steel
company, United States Steel. The president had indicated an interest in wage-price relationships before his inauguration, and the Council of Economic Advisers duly followed up in its 1962 report by setting guidelines for non-inflationary wage-price behavior (Heller papers, Box 4, January 5, 1961). President Kennedy used the guidelines when he wrote to the heads of the steel companies and the union near the end of 1961, asking them to avoid a price increase and an inflationary wage increase. The president thought that he and Secretary of Labor Arthur Goldberg had negotiated a steel wage increase that was within the government’s wage-price guidelines based on productivity increase, so there should be no change in steel prices. When the companies announced price increases on April 10, the administration forced them to cancel the announcement by starting an investigation of pricing practices, shifting defense contracts to smaller companies, and issuing statements critical of the increase. Within three days, all companies rescinded the increases.
¹⁶⁸
The incident led many to believe that the administration had taken an anti-business tack. Stock prices started to fall before the confrontation. They fell 4.3 percent in the next four weeks and more than 20 percent in the second quarter, more than eliminating the entire gain for the previous twelve months.
¹⁶⁹